This is an extract from a recent report “How Fossil Fuels Drive Inflation and Make Life Less Affordable for Canadians” prepared by the International Institute for Sustainable Development. This report summarises how fossil fuel price volatility drives inflation in Canada, underscoring the need to transition to renewable energy for cost savings and economic stability. It highlights the importance of policies supporting electrification and reducing dependency on fossil fuels to mitigate these impacts.
The Fuel Price Rollercoaster
Fossil fuel prices are known for volatility. This volatility is largely unavoidable as oil and gas are subject to the boom-and-bust commodity cycle. International conflicts further contribute to this volatility. Historically, natural gas markets have been regional and, as a result, better insulated from global price shocks. However, this is changing due, in part, to the growth of transcontinental and international pipelines for exporting natural gas resources. Increased integration between regional natural gas markets and the global liquified natural gas (LNG) market also means that fluctuations in the latter can impact regional prices. In Canada, consumer reliance on fossil fuels magnifies the impact that price spikes and supply disruptions have on the economy. In 2022, the main sources of primary energy consumed in Canada were natural gas (38.1%), refined petroleum products (35.0%), followed by electricity (23.5%). Many provinces still rely heavily on fossil fuels for their power production. While provincial policy and market design drive electricity rates, fossil fuel prices also directly influence the cost of electricity generation.
Canada’s energy reliance on fossil fuels means that energy prices are the most volatile component of overall inflation in the country by a significant margin, noting it far outstrips goods, foods, services, and shelter by a wide margin both in terms of positive and negative influence on inflation. Fossil fuel price volatility is expected to continue and worsen as climate-related disruptions impact infrastructure, supply, and demand. The Canadian wildfires of 2016 and 2023 also abruptly impacted North American oil prices. In both years, oil prices surged due to lowered production levels, although prices fell again when production came back online. Wildfires that disrupt the oilsands can also create price volatility in the other direction. Alberta oilsands operations account for more than 25% of Canadian natural gas demand, and when that demand is disrupted, intra-Alberta natural gas prices drop.
Why Does Volatility Matter?
Consumers can benefit from lower fossil fuel prices during periods of decline, but abrupt price drops can also disrupt the economy, leading to uncertainty and affecting businesses, employment, and productivity. When prices rebound, consumers are often left unprotected, exacerbating difficulties for businesses and households that are unable to hedge against fluctuating energy prices. Another challenge with volatility is that ongoing and repeated fossil fuel price shocks can trigger self-perpetuating price increases. Increasing energy prices causes inflation in other sectors of Canada’s economy that are sensitive to energy inputs, such as food and homeownership costs, where prices are slower to fall once elevated. With ongoing energy price fluctuations and persistent higher prices amongst other key goods and services, central banks look to strategies to counter inflation, typically through interest rate hikes. Higher interest rates, in turn, put a further squeeze on affordability as mortgage and rental costs increase. This highlights the disproportionate and escalating effect that energy price hikes can have on consumers.
The Spillover Effect of Fossil Fuel Reliance
The economic impact of Canada’s reliance on fossil fuels was particularly evident during the post-pandemic recovery phase. As COVID-19 restrictions lifted in 2021 and economies started recovering, energy demand grew rapidly. However, supply-side challenges arose due to sluggish oil production in key OPEC-plus countries, unexpected outages in LNG supply, and Russia’s invasion of Ukraine, exacerbating already tight oil and gas markets. This combination of demand-side and supply-side pressures led to skyrocketing international oil and gas prices. Global energy consumption expenditures were 20% higher in 2022 than the average from the previous 5 years.
Items that are energy intensive contributed nearly three full percentage points to Canada’s overall inflation in Q3 2022. The costs of these items rise and fall with oil and gas prices. Up to 25% of non-energy items within the consumer price index are sensitive to oil prices, accounting for nearly 60% of Canada’s non-energy inflation in July 2022 and over 85% of the increase since February 2020. Recognizing the systemic importance that energy plays in maintaining price stability, it is imperative to consider and monitor its price volatility and factor it into monetary policy considerations. To combat inflation, interest rate hikes have been the preferred policy of central banks. This approach is meant to curb consumer cash flows in demand-driven inflation scenarios (i.e., excess consumer spending). But when supply-side inflation mounts (i.e., rapidly rising energy prices), interest rate changes have little immediate effect on inflation, and raise loan and mortgage payments for consumers already facing higher prices for energy, goods, and services. In this way, the consequences of combined higher energy prices and higher interest rates are quite costly for consumers. Higher interest rates can also increase the upfront costs of clean energy projects in a feedback loop that slows the energy transition. Subsidizing fuel costs keeps prices artificially low, reducing incentives for energy efficiency and fuel switching, and keeps consumers stuck on the fuel price rollercoaster.
Increasing Affordability with Clean Energy Transition
Canada can mitigate future inflation and help make life more affordable for Canadians by supporting a transition away from fossil fuels. In fact, putting the global energy system on a path to net-zero by 2050 could reduce energy operating costs by more than half by 2035. There is opportunity to lower energy costs by reducing the overall amount of energy used through more energy efficient technologies or by changing behaviour (e.g., driving less). Electrification of transportation, heating, and cooling can also save money. This is in part because electric vehicles and heat pumps provide significant efficiency gains over their fossil fuel counterparts— they use less energy to provide the same service. Therefore, government policies that support and incentivize fuel switching, energy efficiency, and changes in behaviour will help smooth and accelerate the transition away from fossil fuels. Options for cheaper and cleaner energy are reliant on the availability of infrastructure and services such as efficient public transportation, electric vehicle charging infrastructure, and clean, reliable electricity supply. Although significant investment is required to build supportive infrastructure and services, it is a long-term investment that can both boost Canada’s economy and lower the costs that Canadians pay for the services they need
Lower Costs with Clean Electricity
While only 18% of Canada’s electricity generation is from fossil fuels, there is considerable variation across the country. Provinces with the highest amounts of fossil fuel generated electricity are Nunavut (99%), Alberta (81%), Saskatchewan (79%), Nova Scotia (59%), Yukon (32%), and New Brunswick (30%). Although coal use has dropped, natural gas use for electricity generation has increased significantly from 3% of total generation in 1996 to 16% in 2022. Expanding natural gas generation increases the entire system’s exposure to volatile energy sources and risks higher costs for producers and higher prices for consumers. When looking at the long-range operating costs of gas-powered electricity, the picture is even more grim. A 2021 study of electricity generation facilities in the EU, United Kingdom, and United States found that due to the volatility of fuel prices and other factors, the economics of gas-fired power generation are growing more fragile. Roughly 31% of U.S. and 22% of European gas-fired power generation facilities are already estimated to be unprofitable, while others are facing increasing risk of becoming stranded assets. Conversely, the cost of renewables has dropped dramatically in the last decade, making it the lowest-cost form of electricity production in most jurisdictions. The levelized cost of electricity (LCOE) dropped 89% for solar and 69% for onshore wind, falling below the fossil fuel cost floor. The cost of these renewables is projected to continue trending downward and will fall nearly 60% below the cost of natural gas production by 2030. In 2023, more than 95% of new utility-scale solar installations and new onshore wind capacity had generation costs lower than new coal and natural gas plants.
Power generation from renewables, specifically wind and solar, can lower and stabilize electricity prices. This is in part because wind and solar electricity does not rely on input fuel to operate. Once built and connected to the grid, renewable energy costs do not fluctuate based on fuel prices. Long-term price stability can be locked in through power purchase agreements that guarantee a price for renewables decades into the future. As a result, integrating renewables can lower electricity prices for consumers. Nevertheless, Canada will require 2.6 to 2.9 times its current electricity capacity to meet increased demand by 2050. A build-out of this scale will require significant upfront investments. Roughly double the rate of current capital expenditure is required, but the savings to Canadian households of transitioning to a net-zero grid by 2050 is estimated at CAD 15 billion annually and roughly CAD 1,500 annually per household. Investments in transmission infrastructure and interconnectors, flexible generation, and specialized forecasting and planning tools, as well as ensuring access to regional electricity markets, are critical. Fortunately, Canada is well-placed to perform in all four categories including a high percentage of legacy hydroelectric power that can provide firm, dispatchable power to complement variable generation from wind and solar.
Canada’s energy system is diverse, and jurisdictional authority over electricity systems and pricing is largely a provincial matter. Provinces and territories with a large share of fossil fuel generation will face the highest costs in the energy transition. These costs may, to an extent, be passed on to consumer ratepayers, and, in some cases, higher prices will result for some, despite longer-term trends that favour affordability and price stability. Policies and incentives can and should be designed to address these regional challenges, including supports for consumers directly through measures on energy efficiency as well as initiatives such as inter-jurisdictional cooperation on transmission interties. Regional challenges have been acknowledged to an extent through the federal government’s announced financial supports for provinces to grow their clean electricity grids. The supports were designed so that provinces with emissions-intensive grids would receive the most support relative to the scale of their existing grid, roughly 33% more than hydro-rich provinces. Through these financial incentives, along with its Clean Electricity Regulations, the federal government is aiming to achieve a net-zero electricity grid by 2035. In addition, policies that provide a level playing field for renewable energy technology and investment will ensure that clean energy industries can remain competitive against fossil fuel incumbency.
Reduce Household Energy Costs
Household energy consumption in Canada is largely reliant on fossil fuels, primarily for heating, exposing consumers to fossil fuel price volatility. Switching away from fossil fuels will lead to more household electricity use in Canada, but an overall reduction in average energy costs of 12% is expected between now and 2050. Additional analysis predicts households could save as much as CAD 1,500 annually. One of the most direct ways to improve affordability for Canadians is by lowering household energy costs through fuel switching, efficiency upgrades, and electrification. Electric air-source heat pumps offer better efficiency and significant cost savings as compared to gas furnaces. Research by the Canadian Climate Institute found that, on average, the lifetime costs of a standard heat pump with electric backup are 13% less than a gas furnace with air conditioning and can cut approximately CAD 55 off the monthly bill of a detached family home in Ontario. Clean Energy Canada has concluded that air source heat pumps “are the cheapest option for many Canadian households, even when the costs of installation are included”.
Reduce Transportation Costs
Personal transportation is another area where fossil fuel-free alternatives provide improved affordability for consumers. Transportation costs accounted for 15% of household spending in Canada in 2021, second only to food (15.4%) and shelter (31.4%). Clean Energy Canada (2023) compared the lifetime costs (10 years of ownership, 20,000 km per year) between various categories of EVs and comparable internal combustion engine vehicles, and found that EVs cost less in all scenarios across Canada, even without a provincial rebate. The Honda Civic, for example, cost an additional CAD 36,000 over its lifetime than a comparable EV. Similar savings were found for hatchback, SUV, and crossover car models as well (based on the average retail gasoline price in 2022—CAD 1.73/litre). Access to EV options is limited to those who can pay the upfront costs, making them still out of reach for many. Innovation and scaling up of manufacturing will lower retail costs over time.
Meanwhile, rebates and incentives can make EV purchases more affordable, and governments can further support EV adoption through the development of charging infrastructure. The federal government’s CAD 5,000 rebate on EVs, as well as rebates available from provincial governments in the Yukon, British Columbia, Manitoba, Quebec, and all the Atlantic provinces, have been helping consumers make the switch. More consumers can be reached by ensuring used EVs are eligible for rebates, as they are in many provinces. While infrastructure investments are necessary, they require sufficient demand to make the investments worthwhile. EV market momentum can be built by better supporting low- and middle income households through a progressive rebate program that is income-tested, ensuring higher income households are not the primary beneficiaries. Making clean transportation accessible is essential to help lower costs for everyone, not just those who can afford to buy an EV. Supporting clean, reliable, and affordable public transportation also increases low-cost options for Canadians while simultaneously reducing transportation-related emissions.
Conclusion
Overdependence on fossil fuels, which are volatile and tend toward high costs, is a problem for Canadian consumers, inflation, and affordability. Record inflation has been driven in large part by oil and gas price increases that have spilled over into other areas of the economy sensitive to energy inputs. By reducing its dependence on fossil fuels, Canada can fight climate change and inflation in a way that supports affordability, shielding consumers from energy price fluctuations by transitioning toward the use of clean and efficient energy sources that have lower and more stable prices. Governments have a role to play to strategically discourage the use of fossil fuels through policies such as carbon pricing, fuel taxation, and fossil fuel subsidy reform. By doing so, they can generate revenue to further support efforts that enhance affordability and incentivize cost saving by switching away from fossil fuels and the resulting energy price fluctuation. It is incumbent on governments to champion policies that expedite the transition to more affordable, efficient, and clean energy in a way that focuses on affordability for Canadians, now and for the future.
Access the complete report here
